Federal Reserve Watch: Moving Along

The Federal Open Market Committee meets again on July 26 and 27.

The policy-making committee of the Federal Reserve will assemble again to determine what the Federal Funds rate target should look like.

Right now, the range for the Federal Funds target runs from 1.50 percent to 1.75 percent. The effective Federal Funds rate has been held steady at 1.58 percent.

Up until Wednesday this week, the best bet for the Fed’s next policy rate move was 75 basis points.

After the latest inflation figure was released, a 9.1 percent rise in June from June 2021, there is more talk that the next move by the FOMC would be to raise the rate by 100 basis points.

That would bring the top of the policy range up to 2.75 percent.

At its latest meeting, the FOMC projection for the Federal Funds rate in 2022 was 3.4 percent. For 2023, the FOMC saw the Federal Funds rate going to 3.8 percent.

So, the Fed still has ways to go in its efforts to bring inflation under control.

Meanwhile, many analysts are calling for an even greater rise in the Federal Funds rate over the next six months or more. Some analysts are even talking about the need for the top of the Federal Funds rate to go to 4.50 percent or even more.

The new inflation figures have just added to the urgency to raise the Federal Funds rate higher, but also to do it faster.

Inflation

Much of the current debate going on concerning the monetary policy of the Federal Reserve has to do with the length of the current wave of inflation.

It seems like the current picture painted by the financial markets is that inflation is not going to last very long. That is, the markets are facing a strong movement in prices, but this strong movement is not going to last very long.

As a consequence, the inflationary expectations built into yields in the bond market are not very great and they imply that the current round of inflation will be falling off quite soon.

For example, calculating the breakeven yield for interest rates on U.S. Treasury securities we see the expected inflation built into five-year maturities and for ten-year maturities are in the two percent range and we also see that inflation is expected to be a lot stronger in the five-year period than in the ten-year period.

That is, inflation over the next five to ten years is not expected to be too much higher than the inflation target of the Federal Reserve System and is expected to be lower over the ten-year period than in the five-year period.

Furthermore, in terms of the impact of monetary policy, we now see the term structure of interest rates now turning negative.

Historically, when monetary policy starts to get tighter, the term structure of interest rates always inverts with shorter-term interest rates rising above longer-term interest rates.

This inversion had not been happening.

Starting on July 5th, a longer-term yield dropped below the yield on the two-year Treasury security.

Since then, more and more of the yields on longer-term Treasuries dropped below the yield on the two-year Treasury.

So, for the first time in this round of monetary tightening, we have an inverted yield curve…even at these very low interest rates.

Thus, the Fed’s tighter monetary policy is being transmitted to the financial markets.

The Securities Portfolio

The Federal Reserve has also included in its plans for a tighter monetary policy to reduce the size of its securities portfolio.

This effort seemingly began three weeks ago.

Looking at the Fed’s balance sheet, the H.4.1.statistical release “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” we see that between June 22, 2022, and July 15, 2022, securities held outright by the Federal Reserve declined by $37.3 billion.

This is not a great amount, but the Fed did not promise that it was going to reduce the securities portfolio by large amounts.

The Federal Reserve is reducing its holdings of securities by allowing securities to mature off the balance and not replacing all of them.

So, the reduction in the size of the Fed’s securities portfolio should be relatively steady and contribute to a relatively calm bond market.

The Fed has initially planned for this reduction to carry over into 2024. The size of the reduction is expected to be over $2.0 trillion, but not by a major number.

Reserve Balances

The Reserve Balances with Federal Reserve Banks, the number I use as a proxy for excess reserves has actually increased over the past three weeks.

The increase has been roughly $190.9 billion. That is, excess reserves have actually gone up as the Fed has reduced the size of its securities portfolio.

There are two reasons for the rise.

First, the U.S. Treasury Department has withdrawn money from its General Account at the Fed during this time by $126.4 billion.

The General Account is the Treasury account used to write Treasury checks on. As the monies leave the Treasury’s General Account at the Fed, they end up in the commercial banking system…hence, the increase in bank reserves.

This Treasury usually collects tax revenues up through the April period and then writes checks on its accumulated balances after the collection period ends.

The second account liability account reporting a decline over the past three weeks is the account for reverse repurchase agreements. The account for reverse repos declined by $73.3 billion over this time period.

In essence, as the reverse repo account declines, securities are replaced on the Fed’s balance sheet and Fed money flows into the banking system.

Bottom Line

So the Federal Reserve is doing what it said it was going to do.

It is raising its policy rate of interest.

It is reducing the amount of securities it has bought outright.

The question is, how much longer will it continue to act in this way?

That is what the market is trying to figure out.

So far, the situation seems to be that the market believes that inflation will not be as bad as it was in June and will become much lower relatively soon. This is consistent with the inflationary expectations in the bond market.

Thus, the market seems to be saying that the Fed will not have to remain too tight for too long a time.

Of course, there are others that argue that inflation will remain higher and that it will stay around longer than what is built into the bond markets right now.

I tend to lean more toward the latter view.